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LOS h: Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE

Optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize:

A)	weighted average cost of capital (WACC).

B)	interest expense.

C)	weighted average cost of equity.

The optimal capital structure is the mix of debt and equity that will maximize the value of the firm and minimize the WACC.

The repayment of a significant amount of outstanding debt will cause free cash flow to equity (FCFE) to:

Debt repayment will decrease net borrowing and, hence, decrease FCFE because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing.

An increase in financial leverage will cause free cash flow to equity (FCFE) to:

A)	decrease in the year the borrowing occurred.

B)	increase in the year the borrowing occurred.

C)	decrease or increase, depending on its circumstances.

An increase in financial leverage will increase net borrowing and, hence, increase FCFE in the year the borrowing occurred because: FCFE = FCFF – [interest expense] (1 – tax rate) + net borrowing.

The repurchase of 20% of a firm’s outstanding common shares will cause free cash flow to the firm (FCFF) to:

Share repurchases are a use of free cash flows, not a source. FCFF is cash flow that is available to all capital suppliers. Notice the conspicuous absence of repurchases in the following: FCFF = CFO + Int (1 – tax rate) – FCInv.

Which of the following statements is FALSE? A firm’s free cash flows to equity (FCFE) is the cash available to stockholders after funding:

A)	capital expenditure requirements.

B)	dividend payments.

C)	debt principal repayments.

A firm’s FCFE is the cash available to stockholders after funding capital expenditures and debt principal repayments.

A)	Companies often use FCFE as a signal of positive future growth prospects while dividends are not used for signaling.

B)	There is no difference. Dividends must equal FCFE.

C)	Dividends are often viewed as "sticky." Managers are reluctant to radically change the dividend payout policy while FCFE often has immense variability.

Dividends and the FCFE are often different and dividends are used as a signal to the market not FCFE. Dividends viewed as sticky is the true statement.

A)	may be higher than free cash flow to equity FCFE.

B)	are always equal to free cash flow to equity (FCFE).

C)	are always less than free cash flow to equity (FCFE).

Dividends represent the cash that the firm chooses to pay to the shareholders and the amount of the dividend is subject to the discretion of the firm. Dividends can be equal to, lower or higher than FCFE. For example, sometimes firms may pay dividends in years when there is a net loss.

Which of the following is least likely to change as the firm changes leverage?

A)	Free cash flows to equity (FCFE).

B)	Free cash flows to firm (FCFF).

C)	Weighted average cost of capital (WACC).

The FCFFs are normally unaffected by the changes in leverage, as these are the cash flows before the debt payments.

Ignoring any costs related to financial distress, if a firm increases its financial leverage, the value of the firm should:

A)	increase because the weighted average cost of capital will be lower due to interest tax shields.

B)	increase because the FCFF will increase.

C)	decrease because the required rate of return on debt is lower than that of equity.

When a firm adds leverage, its value may increase due to the tax shields on interest expense and the generally lower cost of debt. In theory, there is an optimal capital structure. If the amount of debt employed is greater than the optimal, the costs associated with risk of bankruptcy or financial distress begin to outweigh the advantage of interest tax shields.